How do we standardize income statements to express each item as a percentage? Give a hypothetical example

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Question:

How do we standardize income statements to express each item as a percentage? Give a hypothetical example as to how standardizing income statements can be useful to draw comparisons between two companies during a specific period.

Another way to compare firms of different sizes is by using financial ratios. Financial ratios are grouped into five categories:

1.) Short-term solvency ratios

2.) Long-term solvency

3.) Asset management, or turnover ratios

4.) Profitability ratios

5.) Market value ratios

We will begin by learning short-term solvency (liquidity) ratios. The first of such measures is the current ratio.

The current ratio is simply current assets divided by current liabilities;

Current ratio = Current assets / Current liabilities

Another such ratio is the quick ratio. The quick ratio is current assets minus inventory concerning current liabilities;

Quick ratio = (Current assets – Inventory ) / Current liabilities

Cash ratio is simply cash divided by current liabilities;

Cash ratio = Cash / Current liabilities

Here is your second question:

Calculate each of these short-term liquidity ratios for Prufrock Corporation in the year 2010 using the balance sheet on page 53 and income statement on page 54 explain what each means in terms of short term liquidity of the firm. What is the problem with inventory?

Next, we will go over long-term solvency (financial leverage) ratios which address the firm’s ability to meet long-term obligations. The first such measure is the total debt ratio calculated as;

Total debt ratio = (Total assets – Total equity) / Total assets

Say for example that you calculated this number to be .42 which would mean, the company uses 42 percent debt. You would want to compare this number with the industry average to get a sense of whether this number is too high or low.

The second ratio to calculate is the Debt-equity ratio;

Debt-equity ratio = Total debt / Total equity

Or in other words, the company has 42 cents for every dollar of assets. There are two variations of the total debt ratio, debt-equity ratio, and the equity multiplier;

Debt-equity ratio = Total debt / total equity

Equity multiplier = Totals assets / Total equity

In fact, the equity multiplier is (1 + debt-equity ratio), so if we know any two, we can calculate the third.

Times interest earned is;

Times interest earned = EBIT / Interest. This ratio measures the ability of the company to meet its interest obligations. Again, to get a sense of this we would need to compare it with the industry average and through the years to see how it has varied over time. I say, times interest earned is 3.6, it would mean interest expense is covered 3.6 times over.

Cash coverage is calculated in the following manner;

Cash coverage ratio = (EBIT – Depreciation) / Interest.

Cash coverage measures how well the firm generates cash from operations and is used to find out how well cash flow meets financial obligations.

Here is your third question:

Calculate long-term solvency ratios for the Prufrock Corporation using the tables referred to in question 2 of this discussion assignment.

Next, we will cover asset management and turnover ratios. The first such measure is the Inventory turnover ratio;

Inventory turnover = Cost of goods sold / Inventory.

The interpretation of this ratio is straightforward. Say, for example, the value you find is 4.6 which would mean the company sold off entire inventory 4.6 six times during the year. A related ratio is days’ sales in inventory;

Days sales in inventory = 365 days / inventory turnover.

Here you plug in the value you find for inventory turnover in the denominator and calculate. We had arbitrarily chosen 4.6 which if we plugged in the denominator would give us 365/4.6 = 79.34 meaning inventory sit about 79 days before it was sold.

Similarly receivable turnover is;

Receivables turnover = Sales / Account receivable.

Calculating receivables turnover would tell us how fast we can collect on our sales. Say, a value of 18 would mean we collected outstanding credit accounts 18 times during the year.

Days sales in receivables are calculated by dividing 365 days by receivables turnovers.

Day’q s sales in receivables = 365 / Receivables turnovers.

Using our arbitrarily chosen number 18 and calculating, 365 / 18 = 20.22 tells us that we collected on our credit sales in about 20 days.

Lastly, total asset turnover is sales divided by total assets;

Total asset turnover = Sales / Total assets

This would simply tell us how much sales were generated for every dollar in assets.

Here is your fourth question;

Calculate long-term solvency measures for Prufrock Company using the tables referred to in question 2 of this discussion assignment and comment.

We cover three profitability measures next namely, profit margin, return on assets and return on equity.

Profit margin = Net Income / Sales

I say, for example, the profit margin is 22%, this would mean for every dollar of sales, the company earns 22 cents profit.

Return on assets = Net income / Total assets.

Return on assets shows profit per dollar of assets.

Lastly, return on equity is expressed as;

Return on equity = Net income / Total equity.

Return on equity shows how much in profit was generated for every dollar in equity.

Here is your fifth question;

Calculate profit margin, return on assets and return on equity for the Prufrock Corporation using the tables referred to in question 2 of this discussion assignment and provide an interpretation for each.

Market value measures are earnings per share, price-earnings ratio, price-sales ratio, and market to book ratio.

Earnings per share = Net income / Shares outstanding.

Say, for example, several outstanding shares are 30 million shares and net income is $600 million. Then earnings per share would equal $20 meaning every share earned 20 dollars.

Price-earnings ratio = Price per share / Earnings per share.

If the earnings per share are $20, and the price per share is $80, then the price-earnings ratio is 4. This ratio shows us how much investors are willing to pay for every dollar of current earnings. A high PE ratio is desirable and may be considered as the firm having high future growth prospects; however, a negative PE ratio can be a result of negative earnings or no profit for the current period.

Price-sales ratio = Price per share / Sales per share.

Say, the price per share is $80, and sales per share are $94, then the PS ratio is 0.85. A low PS ratio is considered a good sign for investors.

Market-to-book ratio = Market value per share / Book value per share.

the market-to-book ratio compares the market value of the firm’s investments to its cost. If the market per share is $80 and book value per share $72, then the market-to-book ratio is 1.11. If the value is more than 1, then we can infer that the firm created 11% additional value for its investors.

Here is your sixth question;

Calculate the market value measures for the Prufrock Corporation using the tables referred to in question 2 of this discussion assignment and provide an interpretation for each.

The next analysis is the Du Pont identity which helps investors better understand the firm’s performance within the industry. The Du Pont identity is calculated by breaking ROE into three parts: operating efficiency, asset use efficiency, and financial leverage of the firm.

ROE = Profit margin x Total asset turnover x Equity multiplier

Profit margin measures operating efficiency, total asset turnover measures asset use efficiency, equity multiplier measures financial leverage. Lower ROE may be the result of weakness in operating efficiency or asset use efficiency. Du Pont's identity decomposes ROE into three components and diagnoses which part may be the cause of low ROE.

Here is your seventh question;

Calculate the Du Pont identity for the Prufrock Corporation using the tables referred to in question 2 of this discussion assignment and provide a concise interpretation.

Understanding financial statements are important both for internal and external users. The managers may use historical accounting information to evaluate the performance of the firm. Investors and creditors can use financial information to make decisions on their investment. When evaluating the financial statements, different benchmarks may be useful such as time-trend analysis or peer group analysis.